Chris Hyzy: Hey. Thanks, everyone, for joining this week’s Street Talk Call. First one of June. We want to touch on quite a few topics, but most notably we want to touch on the latest investment insights report that we titled Five Stages of the Reset Period. We want to dig a little bit more into that but first, what we believe is still going on and will likely continue through the summer months as the market in general; and when we describe the market generally, we're talking about risk markets including equities and some of the lower grade or lower credit areas, lower quality areas of fixed income. We step back and we also take a look at the private market within private equity. Obviously multiples or valuations have corrected, in some cases corrected the most and the quickest. The highest magnitude and the sharpest move lower in the history of capital markets and that is most notable in some of the longer duration big story areas that still are not producing profits that are demanded by investors. So that is obvious. What's less obvious is exactly what the markets are trying to price in and it appears, at least in our opinion, that they're trying to price in three separate scenarios all at once, and that's why you get confusing movements between the two largest asset classes but also you still get confusing and complex gyrations within each of those asset classes. First and foremost, the markets are clear on some days that they're trying to price in a growth recession, which is basically a sharp reduction generally speaking in earnings growth, but does not tip into negative territory overall in the economy. In other words, you don't get a hard recession. You get a growth recession that's just coming off a very high growth levels that we experienced in late ‘20, all of ’21, and then ultimately by the end of this year that high nominal growth coming back down to earth and then ultimately in 2023 coming back down to, on a nominal basis, the level of inflation and when you back out inflation, most likely down to the floor if not at 0% growth. That's a growth recession and that gets picked up a lot in earnings at first and don't forget that the stock market is more highly correlated to the goods side of the economy, G-O-O-D-S, the goods side. It's one of the reasons why the market was going up well ahead of the economy during the pandemic first year of 2020, as spending shifted to goods almost all the time, that high correlation that the stock market has to overall level of goods production and goods demand was most evident. Now that we're shifting more towards services and not necessarily fully away from goods but a greater balance, you're starting to see some of the economic pain that is happening and the goods sector being picked up in the overall stock market while the service side is not falling as of yet and that is not filtering over into the broader economy. So cloudy skies are still out there. Pricing it in, a growth recession does occur some days or weeks. Some days or weeks it appears that the market wants to price in a harder landing in the economy which ultimately results in a recession and still other times the market tries to price in what we call as the newfound recession, which is due to the balance sheet contraction that has never been performed before in this magnitude, you could see access to capital be a lot harder, you could see creditworthiness take a hit, and ultimately, you could start to see some of the areas that grew very, very fast come into question and that's also something that investors may try to price in. So for the time being three separate scenarios from an economic and market perspective, but what we want to focus on is the Five Stages of the Reset Period. First and foremost, the first stage is over, and that first stage generally speaking is an initial move off of the highs in the equity markets with a big rally that happens and ultimately fades. Sometimes that rally pushes you back up towards the new high, sometimes it's just a big move up that doesn't reach anywhere close to the new high and ultimately exhausts itself as investors continue to sell the areas that drove the final push up in the markets. The areas that they recycle back into are not large enough as a weighting in the overall market to make a difference for the sells. So you ultimately get this big rally. It exhausts itself pretty quickly. It's called rolling bear markets underneath the market in certain parts of the market and then at the market or index level, it struggles to move forward to new highs because the weighting in the areas that are being sold is substantially larger than the weighting of those areas that are either benefiting from the new cycle or are just being bought for defensive reasons. So this is indicative of quarter one 2022. We've already passed that.
Stage two, in our opinion, is conditions tighten for real. What does that mean? Well on a monetary basis, the fed raises rates; has been raising rates twice now, March and May; likely to move 50 basis points again in June and July. The fed funds futures market as of today is factoring in a terminal rate all the way through May of ‘23 somewhere between 2.875 and 3.125. We think it's a little higher than that, give it 3.25 – 3.50. So the Federal Reserve continues to bump up rates. The real fed funds rate backing on inflation is still negative, but balance sheet contraction begins to enter in phase three. Phase two is still just conditions tightening, a little bump up in rates, asset managers in this phase reposition portfolios and they extend it into the more defensive areas, not just the areas that are likely to benefit from pricing power like energy and materials and some of the more cyclical areas, but they now are starting to reposition portfolios in a chop and grind type of atmosphere where they’re starting to play more defense. That was second quarter of 2022. Clearly evident in the data that we watch and analyze.
Phase three, financial conditions tighten further. This is where balance sheet contraction begins. That's now. Rates go up. Balance sheet contraction is performed. Overall economic data turns mixed and employment trends begin to show visible weakness. We saw some of that already, but we saw some visible data out today from ADP Research. ADP Research has suggested that companies with less than 50 employees - at least ADP Research Institute indicates that these areas have lost 300,000 jobs since February and 91,000 of them occurring in May alone. When you look at the overall data, by the ADP Research Institute, it appears that we have had the slowest hiring month since the pandemic began in May with only 128,000 - according to ADP - of job growth. So we'll see how that filters into the rest of the month, job growth and job numbers, employment data can be rather noisy, but anecdotally we've also seen through the weeks post-February we've seen some layoffs already in certain areas that overbuilt themselves, particularly in the goods sector and we'll see how that filters out again, over the coming weeks, if not months. Higher quality and lower quality areas in stage three of the market begin to correct together and that's where equity allocations generally are taken down. Those who have enjoyed substantial gains begin to get more risk averse, begin to raise cash, and/or lower short duration, lower duration overall in fixed income. Now that’s stage three. That can last in our estimation anywhere up to three to six months overall before markets try to price in the worst case scenarios. Within this phase three at the middle and tail end of this you start to see earnings deterioration, not just estimate revisions lower, but actually earnings deterioration in the areas that became overbuilt.
Stage four. This is where economic data becomes clearly weak that we have seen but signs of stability begin to appear. What are signs of stability? All of that consumer spending, which ultimately falls in stage three, begins to stabilize out. The job market begins to stabilize as well. Defensive positioning gets too far. It gets too extended and multiples ultimately correct to levels that become attractive again and at the same time, the earnings decline begins to end. We foresee that more of a 2023 type of scenario, not necessarily in 2022.
Stage five is where a new market cycle is firmly established, which converges back into the long term secular bull market trend and that brings me to my final point. We firmly believe that this cyclical bear market that started underneath the index that just hit at the top of the index as measured by the S&P 500 two Fridays ago when intraday we fell into bear market territory, this cyclical bear market continues to do chop and grind and consolidate its way through until the broader economy starts to show its general weakness in real terms and the Federal Reserve continues to move rates up and contracts the balance sheet where financial conditions ultimately are likely to go too far. It is our belief that the fed may actually have to stop balance sheet contraction at some point in time before they stop their rate increases. As all of this is happening, what we did is we looked at the strategy analysis, the technical strategy analysis by BofA Global Research, Steve Suttmeier’s area, and we looked at areas of recession within cyclical bear markets that were in a long term secular bull market. His analysis/their team’s analysis shows that recessions do occur during secular bull markets. It's certainly not the official economics team’s call at this point. We still need to see more data before we can consider a recession above the 50% level, but as of now, recessions do occur during secular bull markets, but the magnitude of the market weakness is significantly different than if you were in a longer term secular bear market period like the ‘70s and early ‘80s. The 1950 - 1966 bull market had three recessions in those 16 years. The 1980 - 2000 bull market, those twenty years had two and the 2013 to present secular bull market has had one; obviously in the beginning of 2020. The silver lining here is that the S&P 500 pullbacks associated with recessions during secular bull trends are much less severe and have averaged about 22% peak to trough in terms of the move lower rather than the average of almost 40% drawdown during recessions in which pullbacks happen during the secular bear market. So when looking at recessions it's important to know what long term trend you're in. Are you in a secular bull market trend or a secular bear market trend? The difference between the two’s pullback is almost by 50%. In other words 22% relative to 40%. So from our standpoint, the market continues to try to price in a growth recession. Ultimately, that's the base case where earnings ultimately settle down at levels off of their peaks. Markets have already corrected their valuation by over 20% - 23% already. That is generally in line with prior periods. Now once earnings showed their mettle in the coming six months, that's where we believe the secular bull market ultimately begins to resume once again. For now it's chop and grind.
For now it's repositioning and portfolios in the next cycle and at the tail end of this cycle in our opinion needs three attributes to consider. Number one, first and foremost and we've talked about this before, as diversified as possible across and within asset classes. That goes as far as we're concerned geographically as well ultimately as on a sector basis within the US. Both have a balance and be on guard and use factors to your advantage. Dividend growth is important. Total return is important. Quality is much more important than the previous cycle where lower quality generally speaking outperformed. Strong mix between growth and value, if not one or the other and ultimately on an individual company basis, great operators that have some level of a pricing power have the ability to control the supply chain a little bit better and obviously produce something, whether it's a service or a good, that's more in demand than when the supply can be produced. So all of these attributes in the coming cycle and at the tail end of this cycle are all very important. We also firmly believe that innovation hasn't gone away. It may be paused right now. It may have been overbuilt for obvious reasons particularly during the pandemic, but the leaders of the next cycle are clear innovation leaders. That's how leaders are born, that's how they develop and ultimately mature, and now new leaders are being born, developed, and mature in the private markets and ultimately spawned into the public market. Some we all know about. Some have yet to be created, but in the next cycle as we continue to advance the innovation economy particularly in the US and around the globe, control of domestic supply chains are going to become more important; renewables more important; obviously electrical vehicle production and the chain that is involved in that more important; the next evolution of the cloud, cyber security, chip production, etc. All of this is not going away. It's simply on pause. Many of those companies got overbuilt, overvalued, and now need to produce profits in the coming cycle.
Last but not least, diversification not just across and within sectors, but also considering for those more investors able to withstand less levels of liquidity and for those qualified investors, alternative investment in terms of allocations. The consideration there is to increase the allocation and that also includes reflationary or inflation beneficiary areas with our belief that inflation is likely to remain above average even if it starts to come down aggressively which some signs suggest it already has. We're looking at areas whether it's real estate overall - yes, a pause right now particularly in residential and a big exhale going on in residential real estate - but ultimately the secular bull cycle is still alive and we view this move lower in residential real estate, whether that’s prices eventually or just demand right now, we believe it's a pause and it's a bridge to the next cycle given the fact that Millennials and Gen Z have yet to hit their high income earning years and supply is very hard to come by overall, but we’re still looking at real estate areas, areas that are driving the next cycle whether it's apartments in our estimation, warehousing, storage, all of these areas should be, in our opinion, in strong demand and still difficult low supply. Last but not least, when considering outside of just general levels of alternatives, we still are looking at reflationary type assets through commodities, but more on the commodity production and not necessarily just the physical commodity. Those areas have been under owned for the better part of 20 years, almost two decades, and they're still under owned generally speaking in the investment community from the data that we see and analyze. Overall, diversification matters, long term strategic anchor is the heart of investing. Diversification is the circulatory system and the brains continues to be goals based asset allocation in general. With that, that'll do it for today. Thanks for listening.
Operator: Please see important disclosures provided on this page.
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